School of Civil, Mining and Environmental Engineering

MINE412 MINING ECONOMICS

EVALUATING INCOME PRODUCING INVESTMENTS

There are two basic classifications of investments requiring decision analysis, namely:

1. Income producing investment alternatives.

2. Service producing investment alternatives.

The income producing investments will be examined in this section and the service
producing investments in the next section.

The techniques discussed below are on a before tax and a no inflation basis to avoid
unnecessary complication at this stage. It should be emphasised that economic
evaluation should always be carried out after tax and with inflation effects taken into
account.

1. INCOME PRODUCING INVESTMENT

Income producing investment situation may be subdivided into two classifications,

namely:

• Mutually exclusive alternatives.

• Non mutually exclusive alternatives.

MUTUALLY EXCLUSIVE INVESTMENT ALTERNATIVES

Mutually exclusive investment alternatives are those where several alternatives are
considered from which only one can be selected. This could be the best machine to
install to improve existing operations or the best way to carry out a mining operation
where only a single activity is possible.

Any economic analysis involving a comparison of mutually exclusive alternatives

must be carried out on an incremental or marginal basis.

This is demonstrated in the following examples.

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(a) EQUAL PROJECT LIFE ALTERNATIVES

Three mutually exclusive process improvement projects with 7 year lives being
considered. The company has $800,000 available for investment and any money not
invested in process improvements will be invested elsewhere at rates of return of 10%
(R.O.R.) before taxes.

The optimum investment for the $800,000 is determined as follows:

The details of the three alternatives are:

PROJECT INVESTMENT REVENUE EXPENSES SALVAGE

ANNUAL ANNUAL ANNUAL
A 400,000 200,000 90,000 120,000
B 600,000 300,000 120,000 150,000
C 800,000 450,000 300,000 300,000

Cash Flows: Salvage $120,000

PROJECT"A"
0 1 2 3 4 5 6 7

400,000 110,000

Salvage $150,000
PROJECT"B"
0 1 2 3 4 5 6 7

600,000 180,000

Salvage $300,000
PROJECT"C"
0 1 2 3 4 5 6 7

800,000 150,000

The analysis will be carried out using four analytical techniques.

(a) IRR analysis

(b) Net PRESENT VALUE analysis
(c) Net ANNUAL VALUE analysis
(d) Net FUTURE VALUE analysis

In the analysis of mutually exclusive alternatives, the following steps are carried out:

1. Each alternative is examined to determine that it is economically

satisfactory in its' own right.

2. Incremental analysis is then examined to see whether the additional

investment is justified economically.

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 SUMMARY OF ANALYSIS ANALYTICAL METHODS

PROJECT PROJECT PROJECT

A B (B-A) C (C-B)
(a) IRR 22.63% 25.03% 30.23% 11.21% 0%
ANALYSIS x
(b) N.P.V $ $ $ $ $
ANALYSIS + 197,064 + 353,220 + 156,156 + 84,160 - 269,060
x
(c) N.A.V + 40,485 + 72,566 + 32,081 + 17,295 - 55,271
ANALYSIS x
(d) N.F.V + 389,970 + 688,260 +298,290 +163,850 - 524,440
ANALYSIS x

Use EXCEL to verify the results in the above table.

From the above summary it can be seen that PROJECT "B" is selected as the perfect
alternative by all analytical techniques.

Another example will demonstrate the need to carry out incremental analysis for
mutually exclusive investment alternatives.

PROJECT INVESTMENT REVENUE EXPENSES SALVAGE

ANNUAL ANNUAL VALUE
A $ 20,000 $ 30,000 $10,000 $ 5,000
B $200,000 $150,000 $50,000 $50,000

Assume that $200,000 is available to invest and any unused capital would be invested
at 10%. Project life is 7 years.
Salvage $5,000
PROJECT"A"
0 1 2 3 4 5 6 7

C=20,000 20,000

Salvage $50,000
PROJECT"B"
0 1 2 3 4 5 6 7

C=200,000 100,000

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IRR Analysis for these projects is

PROJECT "A"
0.9040 0.0055
P.W Equation - 20,000 = 20,000 (P/A i.7.) + 5000 (P/Fi.7)

Try i = 110% = 20,000 (0.9040) + 5000 (0.0055)

= 18,080 + 28
= $18,108

i = 90% = 20,000 (1.0987) + 5,000 (0.0112)

= 21,974 + 56
= 22,030

By Interpolation IRR = 100.35%

PROJECT "B"

P.W. Equation 200,000 = 100,000 (P/Ai.7.) + 50,000 (P/Fi.7.)

Try i = 50% = 100,000 (1.883) + 50,000 (0.0585)

=188,300 + 2,925
= $191,225

i = 40% = 100,000 (2.263) + 50,000 (0.0949)

= 226,300 + 4745
= 231,045

By Interpolation IRR = 47.8%

In this example, if IRR analysis is used alone, then Project "A" would be selected with
100% R.O.R. compared with a R.O.R. for Project "B" of 48%.

However, when incremented analysis is used, the incremented IRR is calculated as

follows:

Salvage $45,000
PROJECT B-A

0 1 2 3 4 5 6 7

C=180,000 80,000

P.W.Equation 180,000 = 80,000 (P/Ai.7.) + 45,000(P/Fi.7)

Try i = 50% =80,000 (1.883) + 45,000 (0.0585)

=150,640 + 2,633
=153,273

i = 40% =80,000 (2.263) + 45,000 (0.0949)

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 =181,040 + 4,271
=185,311

By Interpolation IRR = 41.66%

This shows that the decision should be to proceed with Project "B" because it is more
beneficial to invest the $180,000 at 42% than at the alternative of 10%.

Use EXCEL to verify the above results

(b) MUTUALLY EXCLUSIVE PROJECTS WITH UNEQUAL INVESTMENT LIFE

ALTERNATIVES

The following techniques apply to handle mutually exclusive investments where

service lives are unequal.

It is firstly necessary to find a common basis of comparison, otherwise the economic

evaluation will be invalid.

There are generally two possibilities which are illustrated by the following example.

PROJECT “A”

0 1 2 3 4 5 6

2000 960

Investment $2,000
Annual Net cash earnings $ 960
Estimated service life 6 Years
Interest Rate 9%

PROJECT “B”

0 1 2 3 4

2000 1200

Investment $2,000
Annual Net cash earnings $1,200
Estimated service life 4 Years
Interest Rate 9%

The two possibilities are:

a) The investment is a once off and will not be repeated.

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 b) The investment will be repeated indefinitely.

The techniques to be adopted for these two possibilities are as follows:

INVESTMENT WILL NOT BE REPEATED

The N.P.V. analysis is valid for this case if it is assumed that funds which are released
from the shorter life project are reinvested at the minimum rate of return adopted in
the evaluation.

The evaluation would favour Project “A” with the largest N.P.V.

PROJECT “A” PROJECT “B”

Investment $2,000 $2,000
Annual Net Cash Earnings 960 1,200
Service Life 6 Years 4 Years
Minimum R.O.R. 9% 9%
Net Present Value

4.486
Project “A” 960 (P/A9.6) - 2000 $2,307
3.240
Project “B” 1200 (P/A9.4) – 2000 $1.888

Use EXCEL to verify the above results

INVESTMENT WILL BE REPEATED INDEFINETELY

This is typical of equipment replacements which continue as long as the business

enterprise does.

Three techniques may be adopted although the EQUIVALENT ANNUAL VALUE

method is favoured because of its simplicity of application. The three techniques are:

1. N.P.V. analysis over a time period which is common to both projects

i.e. 12 years in the following example.

2. N.P.V. analysis assuming that each project is repeated in perpetuity.

3. Equivalent Annual Value of each project.

In the following example the same investment decision is reached in favour of

Project “B” with each of the three techniques.

PROJECT A 0 1 2 3 4 5 6

C=2000 960

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 0 1 2 3 4
PROJECT B

C=2000 1200

(1) N.P.V. analysis over a common 12 Year period.

PROJECT “A”

0 1 2 3 4 5 6 7 8 9 10 11 12

960
C=2000 C=2000

7.161 0.5963
N.P.V. = 960 (P/A9.12) – 2000 (P/F9.6) – 2000
= 6875 – 1193 – 2000
= $3,682

PROJECT “B”

0 1 2 3 4 5 6 7 8 9 10 11 12

1200
C=2000 C=2000 C=2000

7.161 0.5019 0.7084

N.P.V. = 1200 (P/A9.12) – 2000 (P/F9.8) – 2000 (P/F9.4) – 2000
= 8593 – 1,004 – 1,417 – 2000
= $4,172

(2) N.P.V analysis in perpetuity

PROJECT “A”

11.11 0.223 11.11

N.P.V. = 960 (P/A9⋅∝) – 2000 (A/P9.6) (P/A9⋅∝)
= 10,666 – 4955
= $5,711

PROJECT “B”

11.11 0.309 11.11

N.P.V. = 1200 (P/A9⋅∝) – 2000 (A/P9.4) (P/A9⋅∝)
= 13,332 – 6866
= $6,466

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 3. EQUIVALENT ANNUAL VALUE

PROJECT “A”

0.223
N.A.V. = 960 – 2000 (A/P9.6)
= 960 – 446
= $514

0.309
N.A.V. 1200 – 2000 (A/P9.4)
= 1200 – 618
= $582
Use EXCEL to verify the above results

NON MUTUALLY EXCLUSIVE INVESTMENT ALTERNATIVES

Non mutually exclusive investment alternatives are those investment alternatives from
which more that one alternative may be selected within the constraints of budget
restrictions.

The objective is to select those investment alternatives which will maximise

profitability.

PRESENT VALUE RATIO ANALYSIS. (P.V.R)

The technique is to rank the investment alternatives by P.V.R. analysis and to select
those which yield the highest ranking.

N.P.V
PRESENT VALUE RATIO P.V.R. =
P.W. INVESTMENT COSTS

The following three investment alternatives where the budget allowance is $100,000.
The projects are non mutually exclusive and the minimum rate of return is 9%.

PROJECT “A”

0 1 2 3

50,000
100,000

Investment $100,000
Net Cash Inflow/Annum $ 50,000
Project Life 3 Years
Interest Rate 9%

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PROJECT “B”

0 1 2 3 4 5

20,000

60,000

Investment $60,000
Net Cash Inflow/Annum $20,000
Project Life 5 Years
Interest Rate 9%

PROJECT “C”

0 1 2 3 4 5 6 7 8

10,000

40,000

Investment $40,000
Net Cash Inflow/Annum $10,000
Project Life 8 Years
Interest Rate 9%

N.P.V CALCULATION

2.531
PROJECT “A” = 50,000 (P/A9.3) – 100,000
= 126,550 – 100,000
= 26,550

3.89
PROJECT “B” = 20,000 (P/A9.5) – 60,000
= 77,880 – 60,000
= 17,800

5.535
PROJECT “C” = 10,000 (P/A9.8) – 40,000
= 55,350 – 40,000
= 15,350

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 PRESENT VALUE RATIO ANALYSIS (P.V.R)

26,550
PROJECT A = = 0.27
100,000

17,800
PROJECT B = = 0.30
60,000

15,350
PROJECT C = = 0.38
40,000

Decision – Select Project “C”, then “B”, then “A”.

In this case with a $100,000 budget allowance select projects “B” and “C”.

17,800 + 15,350
Collectively this yields a N.P.V. of = 0.33
100,000

Use EXCEL to verify the above results

2. SERVICE PRODUCING INVESTMENTS

Service producing investment analysis usually involves an analysis of costs, including

capital, operating and salvage, with no income differences between the investment
alternatives.

The technique of analysis are similar to income producing investments discussed in

the previous section.

Incremental analysis is necessary in order to calculate IRR. because the IRR with the
individual investments will be negative without income.

In the case of PRESENT WORTH and ANNUAL WORTH calculations, the

investment opportunity yielding the lowest total cost will be selected.

An example will illustrate the technique.

An investment of $100,000 in automated equipment will provide a service for 3 years

with zero salvage value and will reduce existing operating costs by $45,000 per year.

Should the expenditure of $100,000 be proceeded with. Assume that the minimum rate
of return is 9%.

PROJECT “A” CAPITAL INTENSIVE

0 1 2 3
Salvage Zero

100,000

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PROJECT “B” LABOUR INTENSIVE

0 1 2 3

45,000

The analysis will be carried out using the same four analytical techniques
adopted for the income producing investments in the previous section.

a) IRR. ANALYSIS
b) PRESENT WORTH ANALYSIS
c) ANNUAL WORTH ANALYSIS
d) FUTURE WORTH ANALYSIS

a) INCREMENTAL IRR ANALYSIS

PROJECT “A” – “B”

0 1 2 3

100,000 45,000
Savings

P.W. Equation
100,000 = 45,000 (P/Ai.3.)

2.283
Try i = 15% = 45,000 (P/A15.3)
= 102,735

2.106
i = 20% = 45,000 (P/A20.3)
= 94,770

By interpolation IRR = 16.78%

Since IRR of 16.78% is > 9%, the minimum rate of return, the acceptance of Project
“A” is satisfactory.

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(b) PRESENT WORTH

P/W. PROJECT A – $100,000

2.531
P/W. PROJECT B – 45,000 (P/A9.3) = $113,895

Select “A” with smallest ANNUAL WORTH.

(c) ANNUAL WORTH

0.395
A/W. PROJECT A – 100,000 (A/P9.3) = 39,500

A/W. PROJECT B – 45,000

Select “A” with smallest ANNUAL WORTH

(d) FUTURE WORTH

1.295
F/W. PROJECT “A” – 100,000 (F/P9.3) = 129,500

3.278
F/W. PROJECT “B” – 45,000 (F/A9.3) = 147,510

Select “A” with smallest FUTURE WORTH.

Use EXCEL to verify the above results

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